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Talk about deep value. Three of Barron's top five performing hedge funds reaped huge gains from mortgage- and asset-backed securities, markets that virtually stopped functioning in 2008. One thing these markets can offer is volatility, perfect for those nimble enough–and confident enough–to maneuver in a fast-moving, chaotic environment.

Don Brownstein, 67, whose generic-sounding SPM Structured Servicing fund is No. 2 on our list with a 49.25% three-year annualized gain, has invested in "interest-only" and "principal-only" strips, among other items. Our No. 5 fund, CQS ABS fund, looks to "take advantage of the differential pricing between ABS [asset-backed securities], credit and equity markets," says portfolio manager Alistair Lumsden, 42. The fund jumped 38.33% a year on average from 2008 through 2010. A sister fund, CQS Directional Opportunities, run by Michael Hintze, ranked No. 13 on our list. (Alas, our top performer, another securitization specialist, Providence MBS Offshore, up 51.46% over three years, doesn't talk to the press.)

A former philosophy professor at the University of Kansas, Brownstein, along with his 12-person research team of mostly Ph.Ds, is constantly experimenting with new models to predict how fast homeowners will pay down their mortgages. A prepaid mortgage means the principal's been returned faster than expected, leaving the investor with a big return on that strip; a slower paydown means the investor is collecting interest for longer, increasing the interest-only piece's value.

Brownstein, who left his tenured position in 1990 to work full-time for one of the early champions of mortgage-backed securities, Ottawa, Kan.-based Franklin Savings, says U.S. housing once seemed invincible, making its fall all the more devastating. Housing-prices nationwide hadn't dropped since the 1950s. Even in the case of default, the underlying asset, a house, always seemed to gain in value. When Federal Reserve Chairman Paul Volcker kept raising rates in 1980 to wring inflation out of the economy, housing prices rose. And rating agencies kept slapping triple-A ratings on toxic MBS "because there was no empirical basis that national-housing prices would drop," says Brownstein, who today runs $2.1 billion Structured Portfolio Management, with $1.2 billion in the structured-servicing fund.

Abetting the market was a shadow banking system comprised of mortgage lenders, brokers, opaque financing vehicles and Wall Street securitization.

Ultimately, however, the mortgage market couldn't defy logic. Seventy percent of Americans live in single-family households, and 82% of seniors, 70-years or older, own homes. "You run out of people" who are eligible to buy, he says. So lenders and brokers sold to the ineligible: The number of Ninja mortgage loans (no income, job or assets) made up 3% to 4% of the mortgage market in 2002-2003 and ballooned to 13% to 14% by 2006, according to Brownstein. "In California," he notes, "the joke was to start at the ocean and drive east 'til you qualify for a mortgage."

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The rest is history. When the market cracked, asset values of mortgage-backed derivatives and mortgage-backed bonds fell to "absurd levels," because no one had ever seen such devastation. Then came the spring-loaded revival in which some issues that had plummeted to nine cents on the dollar more than doubled to 20 cents. Great investment performance "was an accident for a lot people," Brownstein says, "They were in the right spot at the right time."

LUMSDEN OF CQS, which manages $10.1 billion in all, including the $863 million CQS ABS fund, says he and his team also invest a lot of time in developing modeling technology. In CQS' case, they're looking for value relative to, and within, asset-backed securities.

For example, banks are not required to mark their holdings to market. If there was a significant further housing market decline in the U.S., Lumsden would expect the country's four biggest banks to take significantly greater hits from charges against equity. There also may be more pressure to modify delinquent mortgages in costly ways. "Where there is differential between the valuations of financial institutions against the ABS market, we could go long the ABS bond and hedge that holding with a short position in the financial institution's debt or equity. This strategy can be viewed both as a hedge and a relative value trade, where both sides make money," he says.

Another potential trade is in Europe, where banks haven't divested non-performing structured debt the way their U.S. counterparts have. If inflation escalates and high unemployment persists, rates could rise and the non-performing loans could be sold off at a discount that's not reflected in recent pricing, says Lumsden. "We would take advantage of the downward revaluation by shifting a significant part of the portfolio into European ABS. As demonstrated in 2008, discipline and market timing are very important, " he adds.

Looking ahead, Brownstein expects the U.S. economy to muddle along with low interest rates. "I don't see runaway inflation but maybe inflation above the Federal Reserve's target of 1.75% to 2%." Recent unemployment numbers have been good but less than a solid recovery would suggest. "The most encouraging sign is that people are getting the sense they can get a job and are re-entering the workforce," he says. At some point, they may start buying houses again, too.